Entity Theory

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21 Aug, 2024

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What Is Entity Theory?

The entity theory refers to an accounting concept and a legal theory that assumes that the business activities conducted by an organization are distinct or separate from those of the owners. It allows the computation of losses and profits among several related transactions.

This theory applies to limited liability companies (LLCs) and corporations. In this case, the owner's finances are separate from the business. Hence, creditors cannot get hold of the owner's assets to recover debt yet to be repaid by the company. It is the opposite of the proprietary theory, where the distinction between the business and its owners does not exist.

What Is Entity Theory?

The entity theory refers to an accounting and legal doctrine that considers business organizations separate from their owners. It helps gauge a company's performance separate from the owners based on multiple parameters, such as profitability and cash flows.
This accounting concept applies to limited liability companies and corporations only. Unlike the proprietary and aggregate theories, it does not apply to partnership or sole proprietorship businesses.
There are some key characteristics of LLCs or corporations according to this theory. For example, they are a separate legal entity, and their shareholders have limited liability.

Entity Theory Explained

The entity theory refers to a fundamental concept that assumes that a business's actions are separate from the owners. This theory's assumptions safeguard the shareholders and owners from needing to fulfill the organization's financial obligations or loans. This is an undeniable advantage for them as it eliminates the chances of losing their personal properties or assets.

Under such a theory, a person or a group of individuals working as a company gets treated like a separate accounting and legal entity. Thus, it essentially establishes an artificial person. Any person doing business with that organization is considered to be engaging with the organization, not the individuals they are dealing with, in the accounting and legal senses. This enables accounting for transactions collectively.

This theory plays a crucial role in ensuring that an organization carries out its business-related activities smoothly via the separation of control and ownership. The general understanding is that the theory came into existence around 1600. The British Jurist and Politician Lord Coke promulgated it, declaring that corporations are artificial persons or separate legal entities that a sovereign power establishes.

Grouping the transactions' accounting under different entities means that one can compute the losses or profits and the relevant assets' net value more straightforwardly to facilitate judicious economic decision-making.

The cases of Dartmouth College v Woodward and Salomon v Salomon & Co. Ltd. were two milestones in the business entity theory's origins.

Characteristics

According to the entity theory in accounting, some characteristics of corporations and LLCs are as follows:

The shareholders of the organizations have limited liability.
Profits belong to companies until they declare dividends.
Obligations arise only due to acts of the business's officers or agents.
A corporation is a going concern. This means that it has a perpetual existence despite the changes in its shareholders.
LLCs and corporations have their own name. Moreover, they have a separate legal entity. In other words, they have an identity different from their owners.

Accounting Treatment

As noted above, this theory separates a business's activities and its owner's finances. Hence, the accounting treatment in this theory's case clearly reflects the distinction and autonomy. The entity accounts do not include the owners' personal liabilities and assets. The income statement computes the revenue for a certain period and entity.

Under this theory, the accounting equation for companies' balance sheet represents an organization as an entity on one side against two different or separate entities — the creditor and the shareholders. The equation is as follows:

Assets = Shareholder's Equity + Liabilities

Where:

Shareholder's Equity = Assets that are available to stockholders after paying off all liabilities

Liabilities = All long-term and current obligations and debts

Criticisms

Although the entity theory in accounting was introduced a long time back, it has not been able to gain more recognition globally. This is because many researchers have criticized this theory. Indeed, various experts suggest that a firm cannot be independent from its owners. Rather, the organization is a source the owners utilize to make profits.

In some way, the earnings are linked with the managerial committee and owners' interests. This is because their motives are identical to those of the organization's shareholders. This means the organization's owners invest in the business to generate returns. Apart from contributing to the organization's capital structure, such investments include hard work, effort, time, knowledge, etc.

Entity Theory vs Aggregate Theory vs Proprietary Theory

The entity, aggregate, and proprietary theories can confuse people new to the financial world. Individuals unfamiliar with such concepts must know their differences to understand the meaning clearly. Thus, the table below shows how these three theories differ.

Entity Theory	Aggregate Theory	Proprietary Theory
Per this theory, a business's actions are separate from the owners'.	This theory states that a partnership business is not a separate legal entity, unlike a corporation.	It states that there is no fundamental difference between a business and its owner.
This concept applies to only LLCs and corporations	It applies to partnerships.	This theory applies to sole proprietorship businesses, unlike the business entity theory.

Frequently Asked Questions (FAQs)

1. What is social entity theory?

According to this theory, a company is not a private association having individual property rights. Instead, it is a public association that is constituted by legal and public processes. Moreover, the purpose of a company is to fulfill public and collective objectives, and the organization's executives are custodians of shareholders' interests.

2. What is the difference between entity theory and parent theory?

According to the entity theory, an organization owns the liabilities and assets, and the operations are carried out for the owners' benefit. That said, according to the parent company theory, the parent company does not have ownership of the subsidiaries' assets but has control over them if minority interests exist.

3. What is the entity theory of partnership taxation?

Per this theory, the determination of the character and amount of partnership income happens at the partnership level. Moreover, partnership businesses have their tax year and choose their accounting techniques according to this theory.